A Critique of the Leontief Paradox. Diarmaid Smyth Senior Sophister

A Critique of the Leontief Paradox. Diarmaid Smyth Senior Sophister The exploitation of comparative advantage is one of the central tenets of classical trade theory. When Leontief found evidence of a lack of applicability to the real world, a flurry of research was begun to explain these results. Diarmaid Smyth discusses the apparent paradox and explains how the gap between theory and practice was eventually bridged. Introduction The Heckscher-Ohlin (H-O) theorem is one of the most celebrated theorems of International economics. According to the theorem, countries will tend to have a comparative advantage (CA) in the production of those goods that make intensive use of their abundant factor of production. Therefore, a nation will seek to export those goods that use its abundant factor relatively intensively in return for imports of those goods that use its scarce factor relatively intensively. In 1953, Wassily Leontief, using an input-output matrix, sought to test the validity of the theorem with respect to American trade in 1947. At the time, US workers visibly worked with more capital per capita than all other nations, so in accordance with the theorem it was predicted that the US would have a CA in the production of capital intensive goods and should, therefore, export these. However, Leontiefs startling results cast huge doubt on the H-O theorem as US imports were found to be more capital intensive than its exports. This famous conclusion was labelled as the Leontief paradox. The purpose of this paper is to explain why, in fact, the paradox occurred, by primarily focusing on what are known as the natural resource and human capital explanations before going on to discuss the critical importance and modern day relevance of the factor content of trade approach. The Paradox As has been mentioned, Leontiefs 1953 report on US trade patterns revealed that US exports were less capital intensive than its imports. Table 1 shows Leontiefs actual figures, whereby the capital to labour ratio employed in the production of $1 m of US imports was 1.3 times as large as the corresponding ratio used in the production of$lm worth of US exports. Student Economic Review 171 A Critique ofthe LeontiefParadox Table 1. United States trade - Empirical Investigations. Capital and labour requirements per million dollars of United States exports and import substitutes: Leontief: 1947 US Trade Exports Imports Im ports/exports Capital $2,550,780 $3,091,339 Labour (man-years) 182 170 Capital per man $14,010 $18,180 1.30 1951 US Trade Capital $2,256,800 $2,363,400 ""." . Labour (man-years) 174 168 " Capital per man $12,977 $13,726 1.06 Baldwin: 1962 US Trade Capital $1,876,000 $2,132,000 Labour (man-years) 131., 119 .' Capital per man $14,200 ", $18,000 .1.27, Sources: Baldwm (1971) & Leontlef(1953). Leontiefs initial result was further reinforced by subsequent studies of US trade in 1951 and 1962. Furthermore, studies examining. Canadian, Japanese ~nd Indian trade also revealed the existence of the paradox. For example, Bharadwaj's survey of Indian trade showed how Indian exports to the US were capitahintensive despite the overwhelming abundance of labour in India, Even as recently as 1990, the massive gulf between the capital labour ratios in America and :India still existed. Thus arguments in defence of the factor. proportions theorem.on, the grounds that Leontiefs data was unrepresentative do not hold any.weight in -light of these subsequent findings. Therefore, how can we account for the existence ,of the paradox? ,., Leontiefs results led to a wealth of empirical testing and research, as economists sought some answers to the paradox, A number! of theoretical, but ultimately fallacious arguments emerged. For example it'was argued that demand reversals could have caused the paradox whereby US consumers' tastes might ,have been overly biased in favour of capital intensive goods, and consequently US ,imports would have been more capital intensive than US exports. However there is a complete lack of evidence behind such an argument and if anything US consumers had a stronger preference for labour intensive goods. Similarly, the factor intensity reversal explanation of the paradox holds little or no weight, in the sense that although a reversal can exist, it is highly unlikely that factor intensity 172 Student Economic Review Diarmaid Smyth reversals could fully account for the paradox. Finally, although Heckscher-Ohlin assumed free' trade, 00 it has been argued that because the US economy was so heavily protected in 1947, that this may have caused foreign producers to export capital rather than labour intensive goods to the US. However such an argument has also proved to be wholly inadequate and it in fact defies logic upon closer examination. Thus, I will seek to, explain Leontiers results by referring to what are known as the human capital and 'natural resource explanations, which are basic extensions to the H"O model. - These approaches will show how Leontiefs two factor test (homogeneous '0 labour and physical capital) of the theorem was in fact too aggregative and over simplified to such an extent that it obscured many underlying trends. 'j • , Natural Resources A glaring omission fro~ Leontiers two factor test of US trade in 1947 were natural resources (NR)s. Thus, subsequent tests sought to take account of NRs and thei~importance in determining a country's CA and hence their trade patterns. Jaroslav Vanek (l959),'was perhaps the' leading pioneer of the NR approach. \);) '. -, , ... Vanek sought to investigate the NR content of US trade and discovered that the US had become inc~easingly reliant upon the' 0 imports of NR intensive products from less developed countries and Canada in particular. As recently as 1992, the US imported $12.2 billion worth of fuels from Canada while exporting a modest $1.3 billion in return (Table 3). In addition, Vanek argued that physical capital and natural resources,were complementary inputs in production, "we can observe a strong', oegreeofcon:Iplementarity between capital and natural resource reqiIirem~~ts, ';1 In other words, the extraction and transportation ofNR products, such' as' coal and petroleum, required a very large capital investment, and the use of highly capital intensive techniques. As 0 a result, America was indirectly importing capital intensive products because of her reliance on NR imports, As Vanek' concluded": .. it may well be that capital is actually a relatively abundant factor:in . 'the United States. Yet relatively less of its productive services is exp'orted'than 'would be needed for replacing our imports, because resources, which are our scarce factor, can enter productive processes only in conjunction with ~arge amounts of capital,,2 The 0 importa~ce of natural resources in US trade was further confirmed by Baldwin (1971), in his examination of the factor requirements of US exports and importsfor'1962, Using the simple two factor Leontief test, the paradox still existed, with a higher net capital to labour ratio for imports than exports. I, •. I Vanek,1., p152, 1959. 2 Ibid. Student Economic Review 173 A Critique ofthe LeontiefParadox Baldwin, however, taking account of the heavy degree of complementarity between NR products and capital in production, excluded NRs from the data and found that the paradox virtually disappeared, as the import/export ratio fell from 1.27 to a mere 1.04. Table 2. International trade between the United States and Canada. Canada's International trade, 1992 (billions of US dollars). Exports to the US Imports from the US Fuels 12.2 1.3 Other primary goods 4.9 2.3 Agriculture 12.1 6.1 Source: Ethler (1995) Modern InternatIOnal Economics, page 38. Thus studies such as Vanek's and Baldwin's brought home graphically the significance of NRs in US trade and that it is why it is argued that Leontiefs simple test which excluded NRs oversimplified matters to an unacceptable level. Some economists such as Hartigan (1981) have gone so far as to say that when NR intensive industries are excluded from empirical tests, a paradox rarely exists. However Baldwin' s extensive study of US trade showed that although in themselves significant, NRs were insufficient to fully account for the paradox. As a result, further explanations are required. Human Capital As all economists will testify, labour is far from a homogenous factor and ill reality labour skills, educational standards, training programs etc., differ markedly both across and within nations. Countries and particularly wealthier nations invest vast amounts not only in physical capital but also in human capital. However, Leontiefs measure of capital failed to take account of this. Therefore, several economists, such as Kenen (1965), Keesing (1966) and Baldwin (1971) recognised that it was essential that one took into account the differing skill levels of labour, or more generally, human capital. It was hypothesised that because America's labour force was so highly educated that the US should export skilled labour intensive products. Kenen (1965), remarked on the enormous magnitude of sums spent in the US every year in training and educating the labour force and that such investments had outpaced investment in physical capital. 3 By 1957, measured investment in labour was valued at $880 billion or two-thirds as large as physical capital. Kenen obtained a measure of human capital and found that by adding this to physical capital, that the paradox was reversed. In other words, America was found to be 3 Kenen, P., p441, 1991 174 Student Economic Review ----------------------------- Diarmaid Smyth abundant in skilled labour and consequently exported skilled labour intensive products, very much along H-O lines. Keesing (1966), adopted a similar approach, dividing the labour force into eight distinct categories according to skill levels.

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